Netflix: Battle Road Scrutinizes Earnings Quality, Puffed-Up Margins

By Tiernan Ray

The team at boutique firm Battle Road Research today reiterate a Sell rating on shares of Netflix (NFLX), writing that the quality of earnings is dubious and that there is too much emphasis by the company on things such as “contribution margin,” which over-emphasize the health of the streaming video operations, they believe.

The firm offers a $102 price target, based on 40 times the projected EPS of $2.55 in 2014.

Netflix shares today are up $3.04, or 1%, at $261.02.

Battle Road analysts outline four concerns. First is falling gross margin, which they expect will continue to be held down by content acquisition costs:

Investment in proprietary content continues to compress Netflix’s gross margin, which has fallen from 36 percent in 2011 to 29 percent in the first quarter of 2013. We believe gross margin expansion will be constrained by content commitments, which are mostly fixed costs, as well as unpredictable sales growth. At the end of Q1 2013 Netflix’s contractual obligations for content stood at $5.7 billion, $2.4 billion of which appears on its balance sheet, with another $3.3 billion in off-balance sheet commitments.

Next, the analysts question the contribution margin, which they think is puffed up by excusing a lot of costs that they business actually requires:

Netflix calls out the contribution margin of each of its three principal revenue streams, domestic streaming, international streaming, and domestic DVD. A limitation of this reporting convention, however, is that it does not allocate the costs of technology development and general and administrative expenses, which together accounted for 51 percent of its operating expenses in the first quarter, up from 45 percent in the prior year. In its quarterly letter to shareholders, Netflix indicates that its domestic streaming margin increased from 13 percent to 21 percent on a year over basis in the first quarter of 2013, which implies that the operation is getting substantially more profitable. We wonder, however, how much less profitable the company’s streaming operations would be—both domestically and internationally— if the technology development and G&A expenditures were allocated to these operations.

The team offer the following model for what they think the actual margin looks like on a more normal operating basis accounting:

Next, they point out International streaming video, making up 14% of revenue, operates at a loss:

International revenue rose from $43 million to $142 million in the March quarter on a year over year basis. International streaming subscriber additions were 1.02 million in the first quarter, which compared to 1.21 million steaming additions in the first quarter of 2012 and 1.8 million in the fourth quarter of 2012. Total international streaming members were 7.1 million at the end of the quarter, while paid members were 6.3 million. During the first quarter, the contribution margin from international streaming was a negative $77 million, but we note the calculation excludes technology and development and G&A expense. Netflix’s announcement less than 30 days ago that it intends to expand into the Netherlands later this year is likely to place additional margin pressure on operations.

Lastly, they point out the actual negative free cash flow, in contrast to reported profits, as evidence of poor earnings quality:

Despite reporting a paper gain of $16 million in Q1 2013, Netflix was free cash flow negative to the tune of $42 million, a result of content acquisition payments during the quarter, as well as the cost of deploying its Open Connect content delivery platform. If Netflix had not issued new debt, the company would have seen an overall decrease in its cash position during the quarter. With a total debt to equity ratio of 86 percent as of the end of the March 31 quarter, it is troubling to envision Netflix issuing further debt in order to finance its operations.

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There are 4 comments

JULY 16, 2013 3:00 P.M.

fishin_in_the_muck wrote:

YES!!! Finally, someone other than Pendola, addresses the elephants in the room.

JULY 16, 2013 4:33 P.M.

SenoJ wrote:

Totally agree! Very refreshing to see a contrarian viewpoint of NFLX from another source!

JULY 16, 2013 7:56 P.M.

bert wrote:

Can you say 30 million subs last quarter?
Earnings report next Monday---35M?..and in Summer they have always dropped off...but not this year..
it's called International/Worldwide Streaming
Earnings in 2016--90m?
The Big Three Networks model is toast..People will gladly pay way more than 8 Bucks a month---
to watch what they want...when they want....and in720p HD and 5.1 sound.
This could be the stock of the next five years...& I hope it is..I use it & I like it. Thanks, bert

JULY 17, 2013 1:49 P.M.

Jack wrote:

I don't know about others, but this strikes me as awfully short-term analysis. As just one point, it is normal for near-term losses when expanding internationally. They don't address local competition, potential for market penetration and a host of other variables. Yes, expansion into the Netherlands will likely add margin pressure. But for how long? It's a wealthy country where almost everyone's second language is English. Is it wide open or are there strong local competitors? Are there other barriers, such as technical infrastructure, rights fees, legal restrictions? Not addressed here.

They might be right, they might be wrong, but they could have just put this in one sentence: "We don't think they're going to get enough subscribers."

For a long time Amazon lost a lot of money too. It really comes down to if people think Reed Hastings is another Jeff Bezos or not. All I can say is he's been pretty doggone visionary so far, the Quikster fiasco notwithstanding.

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Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.